Many investors haven’t made changes to their investment portfolios since the global financial crisis (GFC). Is now the time to get out of low-risk assets? Craig Keary writes.
After the global financial crisis, many investors moved some or all their investment portfolios to low-risk assets, such as term deposits.
Many haven’t made changes to their investment portfolios since despite a trend of falling bank term deposit rates.
This is causing concern amongst many investors with maturing term deposits. Is now the time to have the conversation with your clients on diversifying their investment portfolios?
The cash conundrum
Since August 2008, Australian investors have seen the official cash rate cut by around half (see Graph 1). In 2010 and 2011, bank term deposit rates did not fall by as much as the cash rate because many of the banks were keen to attract deposits to help with their funding.
This has since changed, with bank term deposit rates falling sharply since their peak in December 2009, as shown below. If there are more cuts to the official cash rate, term deposit rates are likely to fall further.
Based on their rate of decline and the impact of further interest rate cuts, we expect term deposits could be offering less than 4 per cent in the next 12 months.
So how does this impact your clients who were fortunate enough to lock in a high term deposit rate and are now facing the choice to renew or cash in?
If they are looking to renew their terms deposit, they will be investing at a significantly lower interest rate now than they did before.
This decision may have negative implications for those clients needing both income and capital growth to meet their financial goals.
As the trend of falling term deposit rates continues, we believe that it makes sense for investors to consider other investments that offer sustainable income streams (see Graph 2).
These investments may be tax effective depending on investors’ circumstances as well as providing the potential for an appreciation in capital.
Investments such as corporate bonds, listed property trusts, direct property trusts and Australian shares are all offering the potential for income at levels greater than term deposits.
Emotional vs. rational investing
We have seen investors increasingly make emotional decisions about when and where to invest their money. As we know, these decisions may not always be based on rational thinking.
For instance, we have seen investors in various investment cycles move their money to asset classes at the bottom of a cycle that may be less risky but also offer less return just at the point in time when the riskier asset classes are set for a rebound.
As such, you can help your clients understand their drivers for making an investment decision and consider the following:
- Researching the facts – It’s critical for your clients to understand the facts and look at what is actually happening as a result of an event. For instance, when there is an event that causes market volatility to impact returns on long-term investments, they should first determine whether or not their rationale for their long-term outlook has changed before deciding on whether or not to change their asset allocation strategy.
- Asset allocation – Clients who are invested according to a set asset allocation strategy based on rational decision-making should try to avoid changing this strategy when they are feeling emotional. They need to research the facts and look at the long-term strategy that was set and consider if it is still relevant based on balanced and logical reasoning.
- Rational decision making – When markets are stable, clients should look at their investment strategy and asset allocation strategy and use the available facts to make solid investment decisions based on a rational process. Making decisions at a time of extreme volatility may cause decisions to be based on emotion. This may not always be the best decision compared to basing the determination on the facts and available data.
- Working with experts – At times like these when there is a heightened level of emotion around investing, your specialist advice can help your clients make rational decisions.
The importance of income
Income is an important part of generating long-term wealth for investors.
After the GFC, some investors looked to term deposits as a source of income, even though other asset classes could provide both income and capital gains as well as help to meet long-term savings needs.
For instance, a $100 investment in Australian shares in December 1980 would have grown to $874 by the end of August 2011 based on capital growth alone.
If you take into consideration the income from dividends reinvested along the way, the total return would have been $3213.
We consider that dividend income is an equally important source of return as capital growth, particularly for those who are seeking a stable source of income from their investments.
Graph 3 shows that the gap is continuing to widen between the grossed up dividend yield on Australian shares versus the bank one-year term deposit rate.
Investing for the long term can be an important strategy for many of your clients.
To help these clients in their rational decision-making process, you can highlight the long-term historical returns of the different asset classes, as shown in Graph 4 which outlines the relative performance of a number of asset classes.
Interestingly, over the last 10 years investors who remained invested in Australian shares would have the greatest return on their investments.
Another area that your clients shouldn’t ignore is the impact inflation has on returns.
Reviewing their investments returns after inflation will give them a better understanding of their investments’ real worth.
Apart from Australian shares, other asset classes can also deliver sustainable income. Both real estate investment trusts (REITs) and infrastructure funds are two of the alternatives.
REITs are regaining appeal because they are delivering returns of 6-8 per cent a year. This is almost double to what is currently being offered in term deposits.
With the potential for regular returns, there is a strong argument to include REITs as a part of diversified investment portfolios while term deposit rates fall.
Infrastructure funds are another option.
This is due to the fact that they generally have a low correlation with other asset classes and therefore play a valuable defensive role in reducing investment portfolio risk.
They also deliver a sustainable income stream as well as providing diversification to investors’ portfolio.
Due to these characteristics we have seen investors look at this asset class as an alternative investment as term deposit rates fall.
Overall, the trend of falling bank term deposit rates, the potential of sustainable income from non-cash investments and the need for investment portfolios to have both income and growth to meet financial goals are the main reasons why we believe the time to have the conversation with your clients about diversifying their investment portfolios is now.
Craig Keary is director and head of retail and corporate business at AMP Capital.
